4) Understanding and valuing options Flashcards
long call option
right to buy asset
short call option
obligation to sell asset
long put option
right to sell asset
short put option
obligation to buy asset
american option
exercised at ANY TIME prior to and including expiration date (more flexible, usually higher value)
european option
exercised only on the expiration date
how are position diagrams different to profit diagrams?
only show payoffs at option exercise price, they don’t account for the initial cost of buying the option or the initial proceeds from selling it
protective put
A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis.
involves holding a long position in the underlying asset (e.g., stock) and purchasing a put option with a strike price equal or close to the current price of the underlying asset.
aim of protective put
limit potential losses that may result from an unexpected price drop of the underlying asset.
to go long on a call option
investor hopes to benefit from an upward price movement in an asset. The call gives the holder the option to buy the underlying asset at a certain price.
go long on a put option
an investor who expects an asset’s price to fall—will be long on a put option—and maintain the right to sell the asset at a certain price.
a short position
is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price.
what is the benefit of a protective put
if you buy a stock and the price starts to drop, you can exercise put option to sell the stock at the higher price, even though present price is far lower.
Straddle (unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience significant volatility in the near term)
simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.
when is a straddle strategy popular
when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.
Determinants of the value of a call option
- Increases with the ratio of the asset price to the exercise price
- Increases with interest rate and the time to maturity
- Increases with the variance per period of the stock return multiplied by the number of periods to maturity
Determinants of the value of a call option:
2. Increases with interest rate and the time to maturity
a. When you own an option, you know that it will be exchanges for a stock at some point. Hence its equivalent to buying the stock but financing part of the purchase via a loan – the amount implicitly borrowed is the present value of the exercise price.
b. Hence higher interest rates mean that the present value of the exercise price falls.
c. Furthermore, the exercise price is paid at a later date. Hence a longer time to expiration increases the time premium.
Determinants of the value of a call option:
3.Increases with the variance per period of the stock return multiplied by the number of periods to maturity
a. Higher volatility of stock prices will allow more chances for the option to be exercised – more upwards potential.
b. You would like to hold a high volatility stock for a long time.
c. Hence an option written on a risky (high-variance) asset is worth more than an option on safe asset.
Determinants of the value of a put option:
o Cash spent purchasing put options is essentially interest payable, so holder of a put option has a cash disadvantage that depends on the level of the risk-free rate.
price of underlying asset increases
call option increases
put option decreases
price of underlying asset decreases
call option decreases
put option increases
strike price increases
call option decreases
put option increases
strike price decreases
call option increases
put option decreases
volatility of the asset increases
call option increases
put option decreases